What is fear? Why do we experience fear, and how does it affect us? Well, fear is quite simply one of the most basic and primal emotions that we are capable of experiencing. Most animals share this emotion with us, from mice to men. Fear is the drive that takes us away from danger, and takes us toward safety. Fear kept us alive when we shared the grasslands with lions and hyenas.
Wikipedia defines fear as “… an emotional response to a perceived threat. It is a basic survival mechanism occurring in response to a specific stimulus, such as pain or the threat of danger.” However, fear can sometimes be irrational. Just as we can be overconfident and underestimate the danger of a given situation, we can also become fearful and overemphasize the risks.
Trying to play it safe doesn’t sound like such a bad thing. The problem is that good salespeople understand and know how fear works, and they are able to exploit your sense of fear and part you from your money.
I’ll take a look at three ways that this fear is exploited, in a personal finance setting.
Expensive investments
Many personal finance advisors like to capitalize on investor fears in order to peddle over their most profitable products. Most banks offer what is known as a “balanced” mutual fund. These funds hold some stocks, they hold some bonds, and they hold some cash.
The problem is, they usually also charge a high management expense ratio of 2% to 3%. They also usually have an active strategy, which means higher turnover and tax liability. This can kill your returns.
Many banks also offer a “guaranteed” mutual fund investment, which track a given market index or portfolio. These funds protect your principal if the market goes down, but only give you a fraction of the return if the market goes up. The bank and the personal advisors who sell these investments use your sense of fear of the stock market in order to herd you into more profitable investments (for them).
As a short-term investment, these might make a bit of sense, but for a term of anything more than a couple of years, I just don’t see the point. It’s a huge profit win for the bank. If you want a hedge against the market, you can just use bonds or other investment vehicles directly; plus, if you really want to capitalize off of the stock market, you need to be putting more money into it in the bear years, so that you are rewarded during the bull years. This means that you should embrace declines, and not fear them.
In-store warranties
Everyone knows about the special in-store warranties you can get when you buy from a big-box retailer, such as Best Buy. Are these warranties rip-offs? It depends. The stores wouldn’t sell these warranties unless they made money off of them, so that is the first point to consider. The second point to consider is that most manufacturers already have pretty decent warranties, which you are already paying for when you purchase the product. The final point to consider is that many in-store warranties can be between 10% to 20% of the purchase price or more. This implies that you break even only when the product breaks down near 1 out of 5 times. Since most products don’t break down anywhere near that often, this is pure profit icing on the cake for the big-box retailer.
Why do people buy these warranties if they are such a bad deal? Mainly because the salespeople greatly exaggerate the occurrence of breakdowns and repairs, as well as the difficulty of getting a replacement. There is, however, two circumstances in which an in-store warranty can be very helpful: one, when you purchase the item as a gift for someone else and eat the extra cost in order to give them the benefit of the warranty, and two, user stupidity. I once destroyed one of my cd burners by accidentally placing two CDs in the tray. The burner never worked right after that, but I had received the burner as a gift, and it had an in-store warranty, so I went back to the store and exchanged the burner for a new one. I got an upgrade, to boot!
Does this personal experience vindicate in-store warranties? I don’t know. I probably would have had a more difficult time exchanging the burner with the manufacturer, but 10% to 20% of the purchase price seems like an expensive price to pay for a “stupid tax”.
Five-year fixed-rate mortgages
Five year fixed rate mortgages are a big moneymaker for the banks. They are easy to sell, since many people prefer the security of knowing they will pay the same rate over five years over the insecurity of a variable-rate mortgage. The banks have a couple of powerful tactics up their sleeves when it comes to selling these mortgages: first, they scare the customer by implying that interest rates are going to rise, and that they are better off hedging against that risk by going with a fixed-rate rather than a variable rate. They then deliver the coup de grâce by insisting that they had better locked in that 5-year fixed rate or else they will be paying out of their teeth.
There are a couple of problems with the way that the bank is presenting the facts. First of all, for those of us living in Canada, the mortgage system is set up so that most terms roll over every 5 years. If you have a 25 year amortization and go with a 5-year term for each, then that means that you will have 5 different mortgages over the 25 years, each with 5 different interest rates. Therefore, even if you go with fixed rates and interest rates later rise, you will still have to eat that increased interest rate once the five years are up. Will the increase be large enough to compensate for the differential between variable and fixed rates?
History tells us that this is not very likely. Since 1975, aside from the time when interest rates were nearing 20% in the late 70s and early 80s, going with a variable rate has been a better deal than going with a fixed rate. With a variable rate, even if the rates do rise, you are still very likely to end up paying less interest than you would have with a fixed rate.
I remember that only a few weeks ago, there was fear and panic that big inflation was starting to set in and that interest rates were going to start rocketing upwards. People were scrambling to lock in fixed-rate mortgages left and right, even if they had to pay near 5% or more to do it. Mark Carney helped fuel the fire by raising the rates a quarter of a percentage point.
Eventually, interest rates probably will return to the mean, but today, the worry is that the economy is not going to recover, we are going to enter into a double-dip recession, and that deflation is more of an issue than inflation. With the recent plunge in bond yields, the pressure is on rates to drop. If they do, it will be a slap in the face to those who gave in to their fears too early.
The way I see it, buying a five-year fixed mortgage is a form of market timing, whereas the five-year variable mortgage is more like a form of dollar-cost averaging. Sometimes, you will get lucky with the market timing and you will come out ahead. Most of the time, however, dollar-cost averaging will win out over the long run.
So, what experiences have you had with salesmen (and women) trying to manipulate you to their advantage, using fear? I left out some good ones like used-car salesmen, so I’d love to hear your stories!
DIY Investor says
I remember a smoke detector salesman playing a video of a house on fire showing people jumping off the roof. Pretty powerful sales technique, I must say.
The biggest fear of the elderly is that they will run out of money. Sometimes reverse
mortgages exploit this fear although in some cases they are appropriate.
Kevin says
I’ve seen advertisements recently for life insurance “annuities that provide a guaranteed return and payout, regardless of the performance of the stock market!”. When I actually go and calculate the return, it barely matches inflation! However, people don’t see this, they see a stable payout.
Without some financial education or a second opinion, or if they are very risk adverse, they might see this as preferable to investing in the stock market, even if the odds are the market will give them vastly superior returns, with just a small chance that it won’t even beat inflation over 25 years+.
I think some of the older generation have also developed an anti-stock market investment mentality due to the influence of the great depression on their parents, and that has turned them off to the whole idea of the markets even if they would have done good over the long run. What do you think?
The Passive Income Earner says
Insecurity definitely sell! The first time I got a mortgage they tried to sell me mortgage insurance. It’s like a life insurance in terms of premium except it only covers the mortgage amount remaining… You are better off getting a term life insurance with a constant payout (if you need it that is).
Doing the math and understanding interest calculation is always important I find when it comes to interest and mortgage rates.
Kevin says
Interesting point; I haven’t thought about life insurance too much myself, since I’m still young with no dependents. I know that even at my young age, I should start thinking about it.
In my experience, those guys tend to promote the “advantages of locking in your rate” and psychic variables like that rather than offering any concrete comparisons or numbers. There aren’t that many big banks in Canada, and those are where people turn to first. It’s easier to just exploit the customer’s fear and capture in that extra profit. Getting comparative analyses and numbers out of them requires extra pressure!
everyday tips says
I just had a real-life experience that showed me the benefit of a warranty. As I blathered about on my blog, my HP laptop died after 18 months because the motherboard died. I was told it would be a 500 dollar fix. Had I bought the warranty, it would have been free. Now keep in mind, I never, ever buy extended warranties, but when I bought my replacement laptop, I did buy the extra coverage, as I obviously do not trust the quality of laptops now.
I am at the point now where I hate buying anything in a store because I don’t want to get all the pressure about buying extra services and such. It is the worst when buying a car, when you have to check all the boxes saying the salesman discussed this and that with you. They try to make you feel like a bad person for not buying all that extra stuff.
Kevin says
I read about your experience with your HP laptop, and I feel for you. There are few things more annoying than having to buy a brand new item after already having spent more than a thousand dollars on something you expected would last longer.
This feeling is what drives many to buy extended warranties. It’s like gambling in a way; a lot of the time, you won’t need it, and you lose your bet, while some of the time, you’ll get back a lot more than you paid. However, the house will always win in the long run.
You also make a good point about those car salesmen; I ignore the extra stuff that they are trying to sell, since the most important parts of the car (drivetrain, protection against rust) usually already have long manufacturer warranties on them of 7 years or more, by which time the car is only worth a few thousand, anyways. Your risk of not taking those extended warranties is pretty small.
I do think that as our potential risk gets larger, warranties (and insurance) start to make more sense. We all buy car insurance, for example, even if we don’t expect to actually crash our car. There also tends to be more competition for things like car insurance, which means the insurance company’s arbitrage is that much smaller.
Thanks for stopping by!
Mich @BTI says
Here’s my real life experience, forked out 400$ for an extended 4 yr warranty on my 2000$ TV back in 2005. The TV worked fine since then which means i paid a 20% premium for NOTHING.
I am sure in some situations it’s worth it, in my case it turned out useless.
Kevin says
Ouch! Well, I hope the TV itself has been worth it!
Thanks for sharing.
Andrew Hallam says
I was told by a friend in the computer business that, generally, if the computer lasts 12 months, it’s not generally a dud, and that extending the warranty to 2 years is generally a waste of money. But then, Everyday Tip suggested that they had a motherboard go after 18 months. Maybe that’s the exception to the rule. I don’t know. Fear does sell though. In the U.S. my wife and her family always bring up “health insurance” when I talk about retiring young. Americans are afraid of any socialized system, it seems. They’ve been scared into spending ridulous levels for private care. Yet the socialized medicine in most of the rest of the first world is the devil, in the eyes of the average American. The capitalistic views of many have scared and delluded most of the people into thinking that they (Americans) have the best health care in the world and that socialized medicine is awful. They are frightened by the unknown. My American friends, what do you think?
Kevin says
Hey Andrew,
I find the topic of health care interesting, since we don’t actually have a completely socialized health care system in Canada. It’s more like a public/private mix, where some elements are provided for by the public sector, some are provided by both the public sector and the private sector, and others are only in the private sector. What many Americans don’t know is that the public system only covers certain forms of health care; many areas are excluded, such as dental and vision.
For example, I believe that dental care is covered by medicare up until 14 years of age. After that, you need to pay out of pocket or with private insurance. Another example would be for medical procedures. If you want an MRI scan, you can wait for months in a public lineup, you can pay $800 out of pocket to get it done in a private clinic, or you can have your private insurance provider pay for it, if you have insurance. You’re not forced to go along with an insurance company’s dictates, as the insurance is decoupled from the treatment, nor are you forced to wait in line if you have the ability to pay.
Every system has flaws, but what is good about our system is that it has choice. I believe it is a recent supreme court decision that opened up the doors to private health care in the country, by a guy in Quebec who wanted to get a hip replacement surgery and was forced to wait for years in the public system.
From what I’ve read, the problem with the American solution, as implemented and proposed, is that you are forced to pay for insurance, and the insurance companies form a powerful cartel, with the ability to lobby the government for favorable laws and regulations which increase their power and keep out competition, as well as control the form and delivery of health care. No wonder their costs are so high!
This is my humble opinion, but I believe that, like any other good, the consumer is best served by competition and choice. The Canadian system provides choice by allowing private service to complement public delivery, as well as subsidized health care for those willing to wait in line or without the ability to pay.
Whether health care should be completely private or not is a political question, but public-only systems (I’m not sure which countries have implemented this, but Canada is not one of them, today) force the entire public to wait, and suffer from an inability to allocate scarce resources properly. Private systems which enjoy special government privilege and are forced upon the public through legislation and regulations are perhaps just as bad, in their own way. I would also love to hear from our American readers what they think about this topic!
Multiple Egg Baskets says
Numbers are a tricky thing and can be used for manipulation…75% of people know this! lol.
When crunching the numbers for mortgages it’s important to know what YOUR goal is and not the institution. If your mortgage broker can not show you where you’re saving money then what do they have to hide?
When reviewing whether or not I should break my current mortgage I trust the numbers at:
http://www.ic.gc.ca/eic/site/oca-bc.nsf/eng/ca01817.html
Give it a try and see if the recommendation matches your mortgage brokers.
Kevin says
Too bad that the guys selling the mortgage often have a conflict of interest with what’s best for you! I like the OCA’s calculators; thanks for linking one of them in!
Andrew Hallam says
Those are good points Kevin, about the health care.
I think Canada has a great system as well, because of the options. And as far as I understand, U.S. medical reform is pushing for something similar, or at least a social net for the poor.
But it’s interesting how many people in the U.S. are brainwashed by the cartel to think that competition will be bad.
I’d love to hear an American perspective on this.
Cheers,
Andrew